Unwise to chase the rally in European equities

Europe

Although the eurozone economy is struggling, European assets have performed strongly in recent weeks as policymakers at the European Central Bank (ECB) have made it clear that they are ready to implement another round of monetary stimulus. Nevertheless, we remain pessimistic about the eurozone economy’s prospects and sceptical of the ECB’s ability to stimulate growth.

The eurozone economy remains vulnerable and growth is weakening…

The eurozone’s expansion has stalled. The manufacturing sector is in recession, having been squeezed by declining Chinese demand and with sentiment damaged by Brexit and the threat of US tariffs against European automobile manufacturers. Household consumption has held up slightly better, helped by rising employment, and the service sector of the economy is still expanding. However, we are concerned that weakness in manufacturing will persist, with forward-looking measures of manufacturing activity still weak, and eventually spill over into domestic consumption. This could cause the economy to enter a vicious circle of negative growth and rising debt; indeed, recent economic data suggest this may already be occurring.

…but markets are reacting positively to expectations of policy response

With inflation also having slowed, this economic weakness coerced the ECB to announce that it was planning to implement further monetary stimulus. Specifically, this could involve more rate cuts and a resumption of its outright monetary transactions policy (quantitative easing). It is likely that these would be accompanied by policies to protect the region’s stricken banking sector, such as tiered central bank deposit rates.

As longer-term investors, we prefer to look at fundamentals rather than short-term sentiment…

We appreciate that the shift towards more supportive policy will boost investor sentiment in the short term, but we are also cognisant that there will be hurdles to overcome in terms of implementation. Furthermore, there are questions over the efficacy of further stimulus at a time when policy is already highly accommodative. European interest rates are already very low and this makes it difficult for banks to profit from their traditional business of borrowing and lending; as such, the financial system remains weak and its ability to facilitate credit creation is reduced. At the same time, debt levels are high and credit demand is subdued, particularly in countries such as Italy and Greece. As a result, the economic effectiveness of lowering interest rates further into negative territory is likely to be limited.

…and we are sceptical about the ECB’s ability to sustain eurozone growth

Meanwhile, the amount of additional quantitative easing that the ECB can undertake is limited by legal restrictions over its total ownership of individual nations’ debt. Although policymakers have indicated that these are not set in stone, politicians in certain countries have previously been rigid in asserting that the ECB is not able to undertake quantitative easing simply to facilitate spending by the region’s underlying country governments. Furthermore, quantitative easing is seen by many as a policy that simply boosts asset prices for the benefit of the wealthy and the rise of populist political parties is likely to increase opposition to the controversial policy’s use.

Meanwhile, there is potential for political risk to increase on the Continent

More broadly, the decline in popularity of the incumbent parties has undermined hope that the Merkel-Macron political axis will be able to push forward with much needed economic reforms in the eurozone. Instead, gains made by the ‘greens’ are likely to act against growth, given that the goals of these parties are generally aligned with environmental concerns.

Overall, we are pessimistic on the outlook for European equities…

Overall, structural headwinds continue to undermine Europe’s growth and the region is increasingly becoming a growth taker, dependent on external factors rather than the strength of internal demand. At the same time, fiscal integration is looking increasingly unlikely; instead we see scope for political risk to increase if growth slows further, particularly in Italy, where the populist coalition government is troubling EU policymakers with regards to its fiscal spending. This could even cause investors to question the euro currency bloc’s ongoing sustainability, with repercussions similar to those seen during the debt crisis of 2010-2012.

Despite their recent strong performance we remain underweight, instead preferring investment in the US and emerging Asia

It appears that European policymakers’ ability to stimulate growth is limited. It is possible that they will come up with new, non-standard policies that will boost economic activity, but we remain underweight European equities for now and believe sentiment-driven rallies can provide attractive selling opportunities. Instead, we prefer investments in regions where growth is stronger and policy has more room for manoeuvre; for example, the US and certain countries in emerging Asia.

 


The above article was previously published by Brooks Macdonald on 11th July 2019